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Gifting or inheriting: What role does Uncle Sam play?

Jon Holthaus Published on 11 September 2015

As we’ve explored some concepts and dynamics of farm transitions over the past few months, we can start to take a deeper dive into some of the pros and cons of potential directions taken.

With any direction, there always seems to be a cost/benefit trade-off that needs to be worked through. There is seldom a perfect solution, but after seeing your situation from multiple points of view, you can start to determine what the most beneficial route is for you and your loved ones.

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When starting a farm transition planning process, it always starts the same way: procrastination. The procrastination is easily justified, in our minds, because there is always something to do on the farm: planting, haying, graduations/weddings (and haying again) in the spring and summer. In the fall, it’s the harvest and preparing the kids or grandkids for going back to school.

Holidays, year-end paperwork and tax preparation keep us busy in the winter. Then we are right back into spring planting again. Is it really that we are too busy, year after year, to start some of the farm transition conversations? Or instead, do we put it off, seeking counsel until we become more educated on the topic? That could be a merry-go-round of frustration.

As an example, think of your farm financial planning (retirement, transition, risk management, estate, etc.) as a game of football, and you are the head coach. How hard (or fun) would it be to draw up a play if you didn’t know the rules of the game?

I would think it would be pretty tough to even know where to begin. But that’s exactly what happens every single day. We often put it off so we have time to “think about it,” but if we don’t know any rules of the “game,” we could ponder on it for years without getting anywhere. Sound familiar?

I can understand the concerns, and it really is a unique situation. The same individuals that can teach us the rules of the game may be (in our minds) the same people we fear may take advantage of us, right? We don’t want to be sold into a solution that’s one-size-fits-all, a trust that may not be ideal, … the list goes on. Find a professional you can trust to inform you on all of the “rules of the game,” which will empower you to essentially design your own “play.”

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Let’s explore some quick rules, or laws, that will help show how you can become empowered.

Gifting vs. inheriting

When it comes to transferring property, what is intended and what actually takes place can be two very different things. I especially see this in the transition of a farm, or property, when assets are gifted versus inherited. The intent and purpose may be for good reason (gifting to protect the farm from the potential of nursing care costs, etc.), but there is a flip-side when all options aren’t considered in your planning.

In its simplest form, when making a gift, the donor’s adjusted cost basis is carried to the recipients of that gift. Leaving out some of the more complex estate tax exemption considerations, etc., let’s look at an example. Mom and Dad bought some tillable acres in 1975 for $50,000. Today, those same acres – with no improvements – are worth $1 million. They have only one heir, Charlie, who they want to pass the farmland on to, but Charlie has no interest in farming.

If Mom and Dad decide to sell those acres today, they will pay taxes on their gain of $950,000 ($1 million - $50,000). Assuming Mom and Dad are at the top federal capital gains bracket of 20 percent (tax code in 2015), their tax liability will be $190,000 ($950,000 x 20 percent).

If Mom and Dad would gift their property to their only adult child (Charlie) while they are alive, Charlie will have the same adjusted cost basis as Mom and Dad. When Charlie sells the property when Mom and Dad pass away, he will still have a tax liability on the gain.

Now imagine if Mom and Dad live for another 20 or 30 years, and the property grows to a market value of $2 million. Charlie’s adjusted cost basis is still at $50,000 because it was gifted during Mom and Dad’s lifetime, so the tax liability is compounded.

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Now let’s take another look at this same example with another angle. Considering another tax rule, if the owners of a property pass the ownership to a recipient upon death, the recipient will receive a “step-up” in basis for the property.

So, for example, considering Mom and Dad have no desire to sell their property during their lifetime, and knowing Charlie will sell the property someday, we would like to maximize the net estate to Charlie. After working with their financial planner, attorney and accountant, Mom and Dad determined it was best in their situation to keep the property in their estate to allow Charlie to receive the stepped-up basis.

Upon their passing, the adjusted cost basis of the tillable acres will get “stepped up” to the current market value. In the case that Mom and Dad both pass away today, with the market value of the land at $1 million, Charlie’s newly established cost basis will be $1 million because he received it by an inheritance when Mom and Dad passed rather than a gift during their lifetime. He could, in essence, sell the property for $1 million and have zero in federal tax liability.

This is just the tip of the iceberg with considerations to weigh. You can see how this one particular “rule” really gets people thinking about the pros and cons of a particular direction. Issues can come up with long-term health care that could sway a decision, among other things.

That is why it is important to address the potential direction of your plan early enough, so solutions like long-term health care insurance, trusts, etc., have the ability to be implemented in a favorable time line and in a more affordable manner.

I encourage you to seek no-obligation consultations with professionals to gather information, or “rules,” when starting your plan. (Please note that these tax laws are applicable to tax year 2015. This law has been up for review in Congress and may differ in the years to come).

In a follow-up, we can explore more questions, concerns and feasibility of strategies for the most beneficial outcome for your family.  PD

Jon Holthaus
  • Jon Holthaus

  • Financial Planner
  • Holthaus Financial Group
  • Email Jon Holthaus

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